ECONOMYNEXT – Sri Lanka’s permanent currency depreciation worsened by periods of greater weakness is putting the country in the danger of political instability and stagflation unless urgent monetary reforms are done to end the debilitating soft-peg that is holding back the country.

This country is part of a group of countries with mis-managed soft pegs which include Philippines, Sri Lanka, India and Indonesia (PISIn) which are struggling with exchange regimes which are neither hard pegs nor true floats.

To move forward Sri Lanka has to end contradictory policy.

Monetary Group

Countries in the PISIn group have drip-drip-drip currency depreciation, high inflation, low real wages leading to the export of labour to countries with better central banks like Middle East and other East Asian nations or to demands for subsidies. But they are not as bad as Argentina, Iran or Zimbabwe.

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India broke free from the worst central banks of the world with the reforms that came after the 1991 balance of payments crisis, but some of the architects of the reforms seems to be no longer at the Reserve Bank of India.

Indonesia, which has a soft-peg is almost as bad as Sri Lanka and is in a sad state despite being an oil producer.

Permanent currency depreciation also leads to high nominal interest rates even if the capital accounts are open.

When currencies depreciate due to inconsistent policy or by deliberate design it is difficult to implement a free trade agency.

Protectionists have a greater say since they can always point to ‘saving foreign exchange’ to demonize imports and build profiteering domestic industries to exploit the poor.Fortunately Philippines and Indonesia have relatively free trade, due to ASEAN membership.

It is sad to see authorities pointing to India, the Philippines and Indonesia as countries which have greater currency depreciation than Sri Lanka.These are the lowest denominators in the peer group. It is a sad benchmark.

Deceptively, countries like Australia are also mentioned, which have floating rates and do not depreciate at all, and falls are temporary based on the policy cycle.

Australian central bankers were first heard talking about inflation targeting around 1993, following the introduction by New Zealand when the exchange rate was 1.5 to the US dollar. The Aussie is now about 1.3 to the US dollar. It was at 0.9 during Bretton Woods. It is a joke to say that Australia depreciated in 2018 to justify a permanently falling Sri Lanka rupee.

Sri Lanka has to benchmark its central bank against countries like Singapore, Taiwan, Korea and the UAE if any progress is to be made and not other PISin group members.

It is an outright lie, that high performing East Asian nations depreciated (or undervalued) their currencies. They did not, as previous columns have shown. Singapore which was 3.0 to the US dollar during Bretton Woods is about 1.2 now.

Even China had a highly credible fixed exchange rate after 1993, following reforms during the tenor of Governor Zhu Rongji. The period of a Middle East style highly credible peg led to rapidly falling nominal interest rates which earned kudos for his successor, Dai Xianglong as the man who permanently brought down interest rates in China.

The exchange rate in Singapore, in China (up to 2005 in particular), in Hong Kong was a tool of domestic stability, and not external competiveness involving near slave labour, as US Mercantilists (or the IMF for that matter) would have us believe.

Sri Lanka also had similar interest rates until rapid currency depreciation started from the late 1970s.

But for much of the period, loose or contradictory central bank policy was made up for by exchange or trade controls, which economists call the impossible trinity of monetary policy objectives.

The massive domestic investment drive of China would not have been possible if the capital was destroyed by currency depreciation.

That nominal interest rates fall when exchange rates are strong is not limited to China. Japan is the most extreme example.

Even in China it can be seen that the volatility of the 3-month rate has worsened after the tightly pegged exchange rate was abandoned. That is probably due to heightened speculative behavior that come from an unpredictable rate.

There is no path to prosperity in devaluationism.There is only, inflation and political unrest, destruction of capital which leads to lower capital investment, and demands for subsidies. China’s 1989 Tianamen square massacre is a case in point which came after several years of depreciation followed by more inflation.

Korea’s Great Workers struggle also followed a period of more than half a decade of drip-drip-drip depreciation. There was more stability in the country when bad policy caused periodic step devaluations.

India broke free of the Hindu rate of growth after the 1991 reforms, with the rupee held at 31 to the US dollar. Step devaluations seem to be better than drip-drip-drip depreciation as it allows for salaries to recover and productivity boosting capital investments to be made.

However there is no substitute for consistent policy of the style seen in countries like Hong Kong, Singapore or the UAE or a true free floating rate.

Weak Side of the Peg

Sri Lanka’s soft-peg is now under pressure with credit picking up, as this column has warned from the beginning of the year.In April, a period of excess liquidity and money printed to repay maturing bonds triggered a period of currency pressure.

In August the pressure was triggered by swaps with the Treasury and excess liquidity.

Subsequently conditions were further complicated by reversal of a legacy swap with National Savings Bank, which expired on September 18.

Graph: liquidity shock <> There is another 249 million dollar swap coming up in next year with NSB.

To stop maturing swaps with the central bank from disrupting the monetary system they should be settled against Treasury bills. That way forex reserves will be lost, but no harm will come to interest rates and therefore the exchange rate, like when the central bank injects cash to keep them at lower rates.

NSB should purchase bills in the market, give them to the Central Bank and get dollars. That transaction will not pass through the reserve money and create a liquidity shortage.

The reason the domestic monetary system is not disturbed when foreign government loans are settled against forex reserves is because finally it becomes a transaction of dollars against bills, with back to back transactions taking place.

In any case the central bank should keep off the swap market. If the Treasury wants to do swaps, they should do it with a commercial bank. The volumes should not be large enough to make the commercial bank go to the window to get money.

Currency Crisis

Any country that has a soft-peg (a reserve collecting peg) with central bank officials reluctant to raise rates is by definition at risk of a currency crisis. The greater the delay in adjusting market interest rate the bigger the fall, and the longer the recovery period.

But Sri Lanka now is not in the same type of pressure for a balance of payments crisis as in 2011 and 2015. For one thing money has been printed and injected through term repo deals for only a month or so. Nominal interest rates are fairly high. Banks are raising deposit rates.

As long as three months bills are not bought off auctions, the central bank is not keeping three month rates down to encourage speculation. It is more difficult to create a full blown currency crisis without keeping these rates down. The pressure can be nipped in the bud faster by raising rates to 8.5 percent so that any float will take hold quickly.

A major change from the 2011 crisis is that oil is market-priced. There is no pressure from CPC borrowings to hit the exchange rate and for central bank to accommodate the credit. As a result interest rates have to rise less to bring stability back.

However if the CPC is not allowed to buy dollars, and the money goes via the banking system to exporters and exporters, the rupee will fall, and the benefit of market pricing will be lost.

It is unfortunate that that liquidity was created and contradictory policy was followed to bring about this situation despite the bold step in market pricing fuel at a huge political cost.

The current pressure on the currency has been worsened by slashing net open position of banks. This drives the credit system to the standard currency crisis territory and makes it more difficult to emerge from the pressure compared to the April-June episode. Overnight rates are 50 basis points lower than the June episode. That also goes against currency strength.

Poster Child

Nomura, a Japanese bank has said Sri Lanka is at worst risk of a currency crisis than many other Asian countries, including Vietnam. Vietnam is the poster child in vogue among Sri Lankan policy makers at the moment, taking over from Malaysia and Singapore, which were touted in the 1980s.

Vietnam is spoiling for a crisis.Vietnam has seen un-ending credit growth for many years now. There is a raging property and apartment bubble. This bubble has already been pricked in Sri Lanka in 2017.

As of last year the State Bank of Vietnam was urging banks to keep rates low instead of raising them.Stocks soared. They pulled back a little this year as soaring valuations led to a sell-off.

Stocks are recovering but stresses began to appear in bank balance sheets from the second quarter.An IMF mission gave the economy a clean bill of health just a few months ago.

“Growth was broad-basedand accelerated to 6.8 percent while inflation remained below the 4 percent target reflecting low food prices and a stable exchange rate,” a June 2018, IMF report said.

“Private consumption continued to be driven by rural-to-urban migration, rising incomes, and a growing middle class.

“It was also facilitated by accommodative financial conditions, stronger bank balance sheets, and an improving businessclimate as reforms continued in the banking sector, privatizations and cuts in red tape.”

The IMF can hardly be blamed for waxing lyrical about Vietnam. It sounds like Vietnam copied the playbook from Regain Sri Lanka in 2001, No?

“The strong economic momentum is expected to continue in 2018, aided by the reform drive, higher potential output, the global recovery, and commitment to macroeconomic and financial stability,” the report went as far as to say.

Even as these words were published, stresses were developing in the balance sheets of the biggest banks in the country including Viettin and BIDV. Whether there will be a full blown crisis or not will depend on how quickly the SBV reacts.

The Executive Board Assessment had some good advice in addition to the standard mantra of the now fashionable inflation targeting.

“Reserve accumulation should continue but more gradually, with fully sterilized interventions,” it said in addition to the usual inflation targeting mantra.

How come no such advice came to Sri Lanka from the IMF (sterilized interventions in this instance refers to purchases of dollars not sales) when central bank allowed excess liquidity of over 50 billion rupees to slosh around both in April and also in July-August generating two currency panics in a row?

However it is bad advice to say to reduce reserve collection (sterilizing purchases tended to compress domestic credit which is not a bad idea considering rising external rates)

Mercantilist Utopia

Sri Lankan (and also foreign) Mercantilists are fond of saying that exports will solve balance of payments troubles. No mention is made of the central bank. They are fond of saying how fast exports are growing in Vietnam.

The Vietnam Dong fell from 16,000 to 20,000 dong during the last balance of payments crisis, exports or not as credit rocketed and the government mistakenly went on a ‘stimulus’ drive. SOE bosses who mis-allocated capital in the bubble have been given death sentences.

But that was 9 years go. There has a long period of currency stability and salaries and real incomes are now higher. Even if the Dong falls, it will be a step devaluation after a long gap, like Korea used to have before monetary reform that built a strong currency.

During the past nine years when the dong was 20,000 to 22,000 to the US dollar people, bought houses, got new motorcycles, some cars, and a large number of new jobs have been created. The country’s vibrant non-traded sector has simply taken off with higher real wages.

Due to inflation and currency troubles in the past, Vietnam is partly dollarized and there is also currency competition from gold.

Vietnam’s currency stability is a recent phenomenon which came in the 1990s primarily after the East Asian crisis, helping fuel an unprecedented growth phase, similar to that of China during the Yuan stability phase.

In the early 1980s the Vietnam Dong was one to the US dollar. It 1986 it fell to 22. It fell to 75 in 1987 and 630 in 1988, 4,500 in 1989, 6,000 in 1990 and about 11,000 in 1992 when the currency was stabilized with better monetary policy and a period of explosive growth began shortly after.

It is no wonder that people hold dollar deposits for zero interest in banks in that country even now. The Dong collapses before the Asian Crises were enough to scare the living daylights out of anyone.

The levels were held until about 1996 when it was buffeted a little during the East Asian crisis. After reaching 15,000 in 1998, the Dong heldaround that level until the global financial crisis and by which time a massive domestic credit bubble was in place. The state engaged in stimulus. That was the last straw.

The Dong fell to about 20,000 – 21,000 and has held until now.

If the Dong crashes over the next 18months the people will be less affected than in a country like Sri Lanka from the devaluation. Many salaries are indexed to the US dollar (officially and under the counter), people also save money in gold and dollars, officially and unofficially.

Vietnam is also a one party state with state media. They can continue reforms, despite economic problems if the peg breaks. There will be no reversals.

But it is a different story in Sri Lanka. Political instability and public unrest can come quickly.

Contradictory Policy

During the Rajapaksa administration Sri Lanka did not want to do reforms and give freedom.

While Vietnam brought foreign investors into the biggest state banks and listed them Sri Lanka bolstered the state sector and expropriated private firms, starving the country of growth creating competitive foreign investment.

An exploitative oligarchy of protected industries were born, which was a cancer on the people. In the services sector such as IT where there was no protection, exports companies were coming up.But the people were protected by a relatively stable exchange rate until the first quarter of 2011.

Monetary and exchange rate policy deteriorated after that. After 2015 policy has worsened again, though the current Governor put the brakes.

However there were no serious reforms of the peg or operating procedures of the central bank, which has brought misery to this country for 68 years.Any soft peg where the central bank tries to target the exchange rate and interest rates (domestic and external anchors) at the same time, is at risk of a currency crisis.

It all blows up when credit growth picks up, either due to state deficit spending or strong private economic activity like in the East Asian currency crisis.

The current IMF program has institutionalized the policy contradictions found in dual anchors.

The IMF program has given an inflation target (domestic anchor) instead of a domestic assets target while forcing Sri Lanka to peg (external anchor) and collect reserves through a net international reserve target unlike in old programs.

This column has pointed out earlier that the inflation target is too wide to protect against BOP problems. What is happening now proves the prediction once again.

Sri Lanka also targeted the Real Effective Exchange Rate adding a possible third anchor to the mix. The IMF has made no public pronouncement against REER targeting either.

In addition to forcing Sri Lanka to follow the monetary policy of the lowest common denominator (countries with bad central banks in the basket), Sri Lanka does not have the tools to target REER and the exchange rate.

Targeting the REER need currency board tools

Let’s assume a 4 percent depreciation a year is needed to keep the REER index at 100. Or Maybe 6 percent in the next 6-months if the REER gets too out of line (it was already above 100 before the latest trouble).

Whether the exchange rate target is perfectly fixed (zero or curency board), or 4 percent, or 6 percent makes no difference. Policy has to be currency board-like to accurately control the exchange rate either at zero or 4 percent.

Controlling the rate at 4 percent is even more difficult because there will be uncertainty and speculation (no credibility), unlike zero when people just forget about the exchange rate.

Depreciating to follow the lowest common denominator down also undermines credibility in the peg. That means interest rates have to float.

It is a serious policy error to think that the REER can be targeted without floating the overnight rates.

Hobson’s Choice: Peg and the Output Gap

The promise of flexible ‘inflation targeting’ is empty; just as empty as the flexible exchange rate.

There can be no inflation targeting with reserve accumulation and a commitment by the Central Bank to repay government debt with forex reserves.

Sri Lanka should not abandon all pretences to a floating style exchange rate as long as it has a reserve target to meet.

The world is heading into a period of volatility. The US dollar is unpredictable. It is floating with an unprecedented load of excess reserves, but with tighter capital rules on banks.

Credit can accelerate and the dollar can fall at any time or conditions can tighten and the dollar can go in the opposite direction.

Pegged countries with strong growth will be most at risk. But even if growth, economic activity and credit are slow, if confidence is weak, the soft-peg will be at risk.

In Sri Lanka, a peg is being operated while something called a ‘flexible exchange rate’ is promised. So far it has been a pretty inflexible downward crawling peg. All policy errors are dumped on the exchange rate like some proverbial trash bin.

Currently there are liquidity shortages due to interventions and maturing swaps, which is also pegging.The longer the liquidity shortages, the more the businesses will suffer. The faster this ends the better.

Sri Lankan does not have the mentality to float. The central bank itself does not, given their public commitment to avoid ‘excess’ volatility, whatever that means.

Sri Lanka is stuck in vicious mish-mash of contradictory policy, institutionalized by an IMF program which requires reserve collection.

Sri Lanka’s 1980s reforms failed to give East Asia-style growth due to bad monetary policy and not just the war.

In the 1980s monetary policy was worse in Vietnam and only a little better in China. It was in the 1990s that China’s and Vietnam’s monetary system began to catch up with better performing East Asian nations providing a foundation for a real take-off.

There is now widespread agreement that the Treasury secretary should be out of the monetary board and that Treasury bills should not be used to advance money to the finance ministry.

But the central bank is now using new methods, swaps and term reverse repo deals, and terminating repo deals to achieve the same objective. After the latest revamp of the central bank website, total Bill holdings against which money has been advanced is no longer clearly visible to the public.

The biggest protection Sri Lanka has against global volatility is the 8.50 percent policy rate: use it.

Nip any pressure in the bud so that people can get back to work quickly. Currency speculation not only distracts from normal work but also saps people.

Don’t interfere in the 3-month Treasury bill markets and keep down longer term rates. That is a killer for the rupee and foreign reserves. Term reverse repo deals are better, but inject money beyond overnight close to the Sri Lanka Interbank Offered Rate and not the overnight rate.

Because Sri Lanka has a peg (see big changes in foreign assets) arguing that rates can be cut because inflation is low (comparatively) to boost growth because there is an output gap is lunacy.

The same story was told in the first quarter of 2015 to start the last crisis. In 2011 rates were cut and cash injected (see red line) to generate that currency crises.